In the mid-1990s, the Wall Street banks came to Koch Industries, asking for help. “We kept getting approached by banks, who say, ‘Hey, Koch. You guys are so good at this physical stuff, we’d like to partner with you,’ ” recalled a former senior Koch executive who was heavily involved in trading operations. The banks came to Koch with the same pitch: the banks would handle “all this financial stuff,” while Koch handled the physical end of trading and shared information from its operations.
If Koch executives were flattered by the attention from Wall Street, they didn’t show it for long. “We kind of got curious—or, suspicious is the better term,” the executive recalled. Rather than help the banks out, Koch set up a team to study why the banks were so interested in their business.
Koch hired the outside consulting firm McKinsey & Company to study what was happening in commodities markets during the 1990s. McKinsey reported that the world of trading had grown even larger and more profitable than Koch Industries had suspected. As it happened, the futures contracts that Koch was trading had become the “plain vanilla” products in a rapidly booming market. Now there were more exotic, more opaque, and far more profitable financial products on the market. These products were called “derivatives.” That’s where the real money was.
A derivatives contract is one more step removed from reality than a futures contract. A futures contract was at least notionally based on the real delivery of a real commodity at some point in the future. But now the banks were creating derivatives that were based on the value of underlying commodities like oil and natural gas, but that never required the delivery of the actual commodity itself. These new products had arcane names like “swaps” and “OTC contracts.”III
When McKinsey gave its report to Koch, trading derivatives was almost entirely the domain of Wall Street banks, which had cornered the market for products that were both complex and financially dangerous. A derivatives contract carried the potential to make huge profits but also the potential to deliver losses that redefined the savagery of a down market. This was due in part to the sheer scale of a derivatives contract. In the physical market, Koch could speculate on a large storage tank of oil. In the derivatives market, it could speculate on the value of ten thousand tanks of oil without ever having to lease an actual tank of fuel in the real world.
Throughout the 1990s, the federal government did all that it could to stoke the size and scope of derivatives trading. The Clinton administration ensured that federal regulators took a hands-off approach to derivatives contracts and did not regulate them in the way that futures contracts were regulated. A typical futures contract was undergirded by a set of rules that made markets more stable—a futures contract required traders, for example, to set aside a certain amount of money in reserve to cover losses or required the trades to be posted on transparent exchanges. When the Clinton administration passed the Commodity Futures Modernization Act of 2000, the law mandated that derivatives would not be treated the same way. The market for derivatives would remain dark, and it would explode in size.
When the Bush administration came into office, the rise of derivatives markets accelerated. Energy derivatives were particularly hot. The Houston-based energy company Enron made derivatives a central part of its business, replacing the boring world of actual energy production with the enticing world of swaps and OTCs.
After analyzing the McKinsey report, Koch Industries decided to put itself in the center of the booming derivatives market, focusing on the field of energy trading. Charles Koch consolidated all of the company’s trading operations under one corporate umbrella that was named Koch Supply & Trading. When managers at the oil refinery in Pine Bend wanted to buy a new shipment of crude oil to process, they did not use their own traders; they simply called Koch Supply & Trading, which did the ordering for them.
Putting all of the trading capacity under one roof would do more than simplify Koch’s operations—it would amplify them as well. That’s because all of the traders would benefit from the information sharing effect that Ron Howell helped engender around the oak table. When a trader at Koch Supply & Trading bought a large shipment of crude oil for Pine Bend, he or she could then place bets in the futures market to hedge the risk of buying so much physical crude at one time. Then a trader sitting nearby could sell a derivatives contract related to the crude product that was just purchased.
Even as the markets changed, Koch’s unifying strategy remained the same. It would enter the new markets using the advantages of its past: the inside information that it gleaned from its operations.
“If you have a physical capability, you have a lot more options. It provides you this physical presence, building up all this knowledge that you can trade around,” said Brad Hall, the executive who ran Koch’s development group and helped clean up the mess at Purina Mills. After the Purina fiasco, Hall became deeply involved in Koch’s trading operations. The success of Koch’s trading desks relied heavily on the flow of information from its refineries and pipelines, according to Hall and others.
Naturally, the consolidated office of Koch Supply & Trading was based in Houston, which had slowly evolved into the Wall Street of energy trading. Koch purchased a building in the southwest part of town, not too far from Rice University, and converted it into a bank of trading offices. The building bore a remarkable resemblance to the Tower in Wichita—it was a cube of dark glass that was inscrutable from the outside. This opacity was fitting because Koch Industries’ trading operation was the one division of the company that Koch was least willing to discuss publicly. Even back in 1981, Charles Koch had insisted on a veil of secrecy around it. When a group of bankers tried to convince Charles Koch to take Koch Industries public, he told them he was worried that doing so might let the world learn just how much money Koch’s commodities traders earned. Koch’s trading profits were so high that Charles Koch worried that counterparties might stop doing business with the company (presumably out of fear that Koch traders made so much money that it must come at the expense of anyone on the other side of a trade).
Charles Koch voiced those concerns at the dawn of modern commodities trading. By the year 2000, the traders’ profits had grown by an order of magnitude, and Koch Industries was even less willing to discuss what happened on its trading floors.
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I. While the Purina Mills fiasco hurt Koch, it did not permanently damage the company’s credit rating, which was based on Koch’s long-term financial track record. By 2016, Koch still had an AA- credit rating from Standard & Poor’s, close to the highest rating reserved for ultrasafe investments like Treasury bills.
II. 100 multiplied by 100 equals 10,000; hence 10,000 percent compliance.
III. OTC stands for “over-the-counter,” which basically meant it was a contract that wasn’t defined by the rules of an exchange. It was just a contract between two parties, tailored specifically to their needs. A futures contract, by contrast, had to meet certain criteria set by the exchanges like the Chicago Board of Trade.
CHAPTER 12
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Information Asymmetries
(2000–2004)